ETF Fee War Blurs Other Costs

October 18, 2012

Index-based investing is getting cheaper, and more confusing.

 

BlackRock is slashing fees for iShares ETFs following a similar move by Schwab last month. Vanguard trimmed its already-low fees back in April, and recently decided to change indexes on nearly two dozen funds in the name of cost savings for investors.

What’s more, these ETF issuers are cutting fees on bread-and-butter funds that provide core exposure—the foundation of a portfolio—not on exotic or little-used strategies.

In other words, these price cuts will affect a huge number of ETF investors that use indexed strategies as the cornerstone of long-term asset-allocation.

But are these low fees here to stay, and what impact will the fee reductions have on retail investors?

Size Matters

To answer the first question simply, size matters, and so does trend.

ETF assets are large and growing, with steady net inflows into ETFs bringing the assets under management total to more than $1.3 trillion, by our latest count. As ETFs grow in size, the fixed costs of running funds shrink, allowing room to cut revenue.

The growth in assets also provides issuers with more muscle to squeeze costs from their supply chains, namely from index providers. Index providers who don’t sharpen their pencil can be replaced, which is part of the back story with the many index changes coinciding with fee reductions.

So issuers feel they can afford to cut their fees. But they’re compelled to actually do so in the name of competition: scratching and clawing for market share.

The Impact On Retail Investors

Low fees are good. A no-brainer, right?

But there’s more than meets the eye. The actual fees that ETFs charge are only part of the total costs investors face. Trading costs, brokerage fees and differences in how funds track their indexes can affect actual expense more than ETF expense ratios—far more, in some cases.

In addition, many retail investors rely on advisors for help. Advisors charge for their services too, and in some cases, subcontract ETF portfolio management to third parties, potentially adding another fee layer, as Jason Zweig recently noted in the Wall Street Journal.

Still, ETF fees attract so much attention precisely because they’re highly visible, fixed numbers. And there’s no doubt that fees make up a part of the layer-cake of expenses that retail investors face.

The takeaway here is to use all-in costs for ETF decisions, and not to rely solely on the simpler headline number—the fund’s expense ratio.

Expenses aside, an ETF’s exposure affects performance too—often much more than the fee—even among funds with similar mandates. While retail investors may not have insight as to which ETF captures a certain market segment best, at minimum they should watch out for unintended overlaps when combining ETFs.

Put another way, indexes really do matter. And, as issuers change underlying indexes as a casualty of ETF fee wars, keeping track of your exposure is getting harder.

 

 

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